The changes to American financial regulation that the Treasury secretary will propose today will raise almost as many issues as they resolve.

The thrust of Secretary Paulson’s proposals is threefold: He seeks to streamline regulation of the financial industry; he suggests broadening the Federal Reserve’s oversight of financial institutions, including investment banks and hedge funds, and he would move the Securities and Exchange Commission toward more “principles-based” self-regulation, such as that which guides the International Financial Reporting Standards adopted by accounting firms.

At the heart of his plan is widespread recognition that America’s regulatory system is obsolete. A Treasury undersecretary, David Nason, has described the financial regulatory structure as having been “knit together over the last 75 years. … We currently have five federal depositary institution regulators, one federal securities regulator, one federal futures regulator, and a state-based insurance regulatory system.”

It is, in fact, a mess. The streamlining proposed by Mr. Paulson would give the Fed oversight responsibility while actually eliminating certain redundant agencies, including the Office of Thrift Supervision and the Commodities Futures Trading Commission, which would be merged into the SEC. These all seem like dandy ideas.

While dumping some agencies, the proposal adds a Mortgage Origination Commission, which would be responsible for overseeing state licensing of mortgage brokers and lenders. Because home ownership is the largest single investment for many Americans, it seems ludicrous that the government does not regulate this function.

To the dismay of Senator Schumer, who has already issued a statement on Mr. Paulson’s proposals, the new plan would do little to rein in the proliferation of complex structured securities such as collateralized debt obligations and structured investment vehicles. These investment products are widely portrayed as the real villains of the current crisis, because they multiplied the impact of mortgage defaults, which often lay at the heart of layered debt instruments.

Mr. Schumer’s frustration is understandable. Many in government have tried and failed to impose some regulation on complex financial derivatives and the hedge funds that traditionally trade them. Even worldly financial types gasp at the reported 32:1 leverage ratio that lay at the heart of the recent Carlyle Capital funds’ collapse. There is a sense in Washington, and on Main Street, that Wall Street has engaged in reckless practices that have now hurt not only so-called sophisticated investors, but all Americans.

The Paulson plan deals with this concern by anointing the Fed as grand overseer of the banking industry, writ large. If the Fed’s discount window will be made available on an ongoing basis to the investment banks, in addition to the commercial banks, then it follows that the Fed’s authority should extend to both groups of institutions. Such oversight is ultimately also planned for other financial services firms such as hedge funds and private equity funds.

This suggestion will attract controversy. A former chairman of the SEC, William Donaldson, says he is concerned that extending the Fed’s “prudential authority” over the investment banks may in some way diminish the power and authority of the SEC.

The investment banks and investment funds will recoil from the possibility that examiners will pore over their trading results and scour their balance sheet entries to forestall credit deficiencies. Legislators, though, may view the plan as the government’s only shot at preventing excessive risk-taking.

Some of Mr. Paulson’s proposals will not likely be implemented any time soon, but the administration may find widespread support among financial industry participants for regulatory changes, as proposals from the Democrats may be far more intrusive. Although he has not yet seen the plan, Mr. Donaldson’s first reaction is that Mr. Paulson may be overly worried about the competitive position of American financial institutions, and not enough about protecting investors.

“We are not going to be the sole marketplace in the world,” Mr. Donaldson says. “If we’re losing our competitive thrust, it’s a function of natural trends,” he adds, referring to the growth and increasing sophistication of international markets. In his view, “the regulatory pendulum should not be pushed back. The subprime crisis makes that clear.”

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